LAQC changes poses tricky decisions (Pharmacy Today – May 2011)

Question:

I am a pharmacist who has invested in a rental property as a way to save for my retirement. Over the last few years I have used the tax refunds from the losses on my property to help fund the cost of the mortgage and other expenses. I have heard that the Government has ended the LAQC regime (my property is held in this structure). What are my options going forward for this property?

Answer:

Recently there have been a number of significant changes to the tax system in New Zealand. You will be aware that the company tax rate has reduced to 28% for accounting periods beginning on or after April 2011. Other changes that took place include the loss of the ability to claim depreciation on buildings, the change in individual tax rates and changes to the loss attributing qualifying company (LAQC) rules.

More than a few of you will own rental properties using the LAQC structure of ownership. From April 2011 it is no longer possible to offset any losses from an LAQC against income in your individual tax return. Because of this, you are likely to want to change the structure from which your rental property is operated. Complicating this picture, the changes to the depreciation rules for buildings may mean your rental property is no longer making tax losses.

As part of the changes, transitional rules have been introduced, which allow us to change to a different entity without tax cost. This had to have been done before 30 September 2011 or if that was not done, between 1 April and 30 September 2012. It is possible to change to a sole trader, partnership, qualifying company, ordinary company, or a new tax entity called a look-through company (LTC), without a tax cost. Below is a simple overview of the implications of the main options:

Weighing up pros and cons

Most of you will be familiar with the implications of individual (or partnership) ownership of businesses. The main difference for this kind of structure, when compared with the LAQC, is the loss of limited liability, which means the owners do not have the protection of the company structure for any claims from creditors. If the property is held in individual or partnership ownership, any profits or losses from the property will flow directly through to the owners of the property.

For many investors, owning a new investment property in your individual name (or names) can be a good and simple option from a tax perspective. For an existing investment property, though, there will be some time, energy and legal costs involved to change the ownership of the property and bank mortgage documents.

If no action is taken, the LAQC will become a qualifying company. A qualifying company can distribute capital gains tax free, in contrast with an ordinary company, where it is more difficult to extract capital gains.

For rental properties that will be making a profit after considering the change in the depreciation rules, doing nothing (the company will automatically become a qualifying company) could be a good option.

The main downside of a qualifying company is that the shareholders have personal liability for any unpaid tax debts of the company.

From April 2011, a new tax entity has been introduced, called a look-through company. Although the company operates differently from the old LAQC companies, the result from a tax perspective is often the same. Some commentators have said that the reasons for creating a new tax entity (rather than just modifying the rules for LAQCs) are political rather than practical!

A look-through company is taxed mostly as if it is a partnership. This means profits as well as losses flows directly to the shareholders of the company. This corrects a loophole that existed for LAQCs, where LAQC losses were able to be claimed by the shareholders in their individual tax returns at their high tax rates and then, when the company begins to make a profit, retained in the company to pay tax at the lower company tax rate.

There are some fish-hooks in the look-through company rules though, which will catch some investors out. The rules contain some complicated loss-limitation rules, which will reduce the ability of some investors to claim losses from the company.

Also, property held through a look-through company is deemed, for tax purposes, to be held by the shareholder directly. For this reason there may be some tax issues (usually with depreciation recovery) when a shareholder wants to sell their shares.

You may also want to think about changing the company ownership to a family trust. If this is done directly, however, there may be a tax cost in the form of depreciation recovery as the property will need to be sold at market value to the trust. One way to get around this could be to move the shares of the current company into a family trust. This option (as well as all of the others) should be discussed with your advisors.

Best to seek advice

The changes introduced in the May 2011 Budget have created some difficult areas for pharmacists, both for their operating companies, if they own a pharmacy business, and for their investment properties. Markhams recommends any pharmacists who currently own property through an LAQC structure seek professional advice as to the appropriate business structure to move into.